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What role does cash play in a portfolio?

Investors hold cash for several reasons, which include holding cash to meet current living expenses or having funds available for emergencies. Cash can be thought of as a store of value, a medium of exchange and a unit of account. “Cash equivalents” are often considered as fixed income instruments with maturities and durations of about one year or less that can help an investor meet their liquidity requirements. Moreover, managing liquidity requirements is an important component of risk management, where a cash reserve can be seen as an asset class that provides advantages for an investor’s portfolio. Essentially, there are three distinct advantages of a cash reserve:

  1. Risk management. This can be viewed as a tool to manage downside risk and thereby mitigate volatility when markets are performing poorly.
  2. Opportunity management. This serves as flexibility in terms of cash that allows an investor to take advantage of investment opportunities.
  3. Liquidity management. This serves as protection of known distribution requirements against unknown market forces.

Given the advantages of holding a cash reserve, managing this portion makes sense conceptually as investors will protect short-term spending requirements in a way that embraces a long-term investment approach.

When looking at figure one below, SA cash has only outperformed SA equity and SA bonds once over the period 2001 to 2016, while SA equity has outperformed SA cash and SA bonds on ten occasions. SA bonds have fared far better in comparison to SA cash, outperforming SA cash and SA equities on five occasions. Over the respective period, an investor would’ve received an average return of 7.96% if they were only invested in SA cash, 10.12% if they were only invested in SA bonds and 17.12% if they were only invested in SA equity. However, it is important to realise that a higher return from SA equity and SA bonds comes at the added cost of taking on more risk. Over the long term investors are rewarded for taking on that extra risk, provided that they stay invested and believe in their long-term investment strategy.

Calendar asset class performance over the long term

Generally, cash performs relatively well in periods of rising interest rates because of its short duration and during periods of high stock market turbulence due to its defensive nature and low correlation to other asset classes. Ideally, a combination of asset classes should assist an investor with their long-term financial goals once an investor’s risk profile and investment horizon are taken into account.

Despite the fact that a primary holding of cash might moderate the overall portfolio’s return when equity markets are rising, this should be seen as an opportunity cost and not necessarily a realised loss. The long-term dampening of a portfolio’s return as a result of holding cash is commonly referred to as “cash drag”, which assumes that investors are predominately invested in equities. However, according to behavioural finance, investors tend to switch from equities after large market declines and are slow to re-invest once markets have bottomed out. The early periods of market recoveries often deliver the strongest performance, whereby missing out during these periods can negatively affect long-term investment performance.

What are the risks of holding too much cash?

Investors who shift from equities to cash, essentially just replace the risk of loss with the risk of not achieving their long-term financial goals. Despite the fact that cash provides liquidity, stability, diversification and that sense of safety, it is not intended to be the primary holding of an investor’s portfolio due to low real returns. This simply begs the question, “what is the ideal cash holding for an investor in their portfolio?”

As with most things in life, the truth lies somewhere between two extremes. Despite the fact that cash as an asset class does not necessarily provide the same level of potential return as it did historically, the long-term data which can be seen in the above figure suggests that it is important within a diversified portfolio.

The appropriate level of cash in a diversified portfolio depends entirely on the investor’s situation after considering their long-term investment strategy, time horizon and risk profile. The advantages of holding cash, which include risk management, opportunity management, and liquidity management are all key inputs when deciding the appropriate level of cash to hold. These are important considerations that an investor needs to raise with their financial adviser as it would help them to understand how much cash to hold when designing an investment portfolio that meets their long-term financial goals.

What are the alternatives?

At the end of June 2016 there was approximately R1.96 trillion in South African domiciled unit trust funds, whereby just under R1 trillion of this amount (roughly 51%) was invested in multi-asset funds. Over the past year, there has been a net inflow of R22.56 billion into multi-asset funds and a net outflow of R5.1 billion out of equity funds. In our current environment, it is not surprising that investors are preferring multi-asset funds as they should provide a relatively stable return profile over most periods.

Ultimately, switching to cash as the primary holding of an investor’s portfolio is indeed a short-term investment strategy, which requires an investor or a financial adviser to time the market. This strategy implies that the investor would need to time the market on two separate occasions, once in terms of when to switch to cash and again in terms of when to re-invest into growth assets. For this reason a multi-asset portfolio is preferred as the asset allocation call will be removed from the investor and will be placed with an experienced portfolio manager who has managed money through various market cycles. Furthermore, this is emphasised by a quote from James Tobin, which stated: “Don’t put all your eggs in one basket”. Tobin suggested that the degree of investor risk aversion should only influence the allocation of an investor’s strategy between risky and cautious asset classes.

Conclusion

A cash reserve is an important allocation within a diversified portfolio that includes equity, bonds and property. Cash provides stability, diversification and a sense of security relative to growth assets. While investors may be grappling with the decision of whether to stay invested or whether to switch to cash during this uncertain time, it is important for investors to begin their investment process by understanding their risk profile, investment strategy and investment time horizon. Furthermore, the use of a multi-asset portfolio is advocated as it removes the asset allocation call from the investor and places it with experienced asset managers who have managed money through various market cycles.

References:

CFA magazine
Moneyweb
PIMCO Research
Schwab Investment Advisory
The Commerce Trust Company
The Economist    

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